Investing in commodities: Profit from a global cornucopia

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1 For professional investors only Not for public distribution March 2011 Investing in commodities: Profit from a global cornucopia Introduction Investors can trade a wide range of commodities, accessing compelling investment opportunities in markets including grains and livestock, industrial metals (such as iron ore and copper), energy (coal, oil and gas), and precious metals (eg gold and rhodium). Rumi Masih, Ph.D. Global Head Strategic Investment Advisory Group (SIAG) Alexandre Christie Strategic Advisor Strategic Investment Advisory Group (SIAG) CONTRIBUTORS Highbridge Capital Management Global Macro Group Sassan Alizadeh, Ph.D. Senior Portfolio Manager Mark Nodelman, CFA Portfolio Manager Vinayak Tripathi, Ph.D. Manager of Research In this paper, we consider the case for commodities as a tactical and strategic investment in the context of post-2008 financial crisis risk management. Specifically we focus on four questions: 1. Is the rise of China and other emerging markets creating long-term imbalances in supply and demand for a range of commodities? 2. Can commodity returns improve the risk and return profile of an overall investment portfolio? 3. Can commodities offer protection against inflation, deflation and changes in the macroeconomic environment? 4. Can actively managed strategies help investors fully capitalise on market inefficiencies in order to boost returns from commodities over the long term? The rising tide: How demand for commodities is outstripping supply Although demand for commodities has historically been largely a product of shortterm cycles in the US, western Europe and Japan, demand from emerging economies such as China, Brazil and India appears to represent a longer-term structural shift in consumption. Emerging market demand is being boosted by rapid industrialisation and urbanisation, leading to the development of large and growing consumer markets. To take one example, the rise in Chinese demand for cars has been a large contributing factor in the increase in demand for some commodities. In 2009, for the first time ever, China displaced the US as the largest single market for vehicle sales. 1

2 Most vehicles sold in China are produced in local factories, which helps explain the growth in Chinese demand for industrial commodities. In the period from 2000 to 2008, China accounted for roughly two-thirds of the growth in global demand for aluminium and steel, and nearly all of the growth in demand for copper and nickel (Exhibit 1). By 2008, Chinese demand made up one-third of the world s total use of steel and aluminium and one quarter of copper and nickel usage. Exhibit 1: China s growing share of global demand for metals Source: Worldsteel, WBMS, Brook Hunt. An ebbing supply The supply of commodities has struggled to keep up with this growing emerging market demand, mainly due to lack of investment in new production. Falling prices in the 1980s and 1990s provided little incentive for commodity producers to build out new capacity or upgrade existing infrastructure. Many manufacturers and other industrial commodity users also adopted just-in-time inventory practices in order to minimise storage expenses. This lack of production capacity and limited inventories has led to supply shortages following the pickup in demand from the emerging world. At the same time, demand for commodities is now being further boosted by the emergence of more and more countries from the global financial crisis. Goldman Sachs estimates that low commodity prices and tighter credit conditions had caused a reduction in global oil production capacity by more than 1m barrels per day by the end of But at the same time capacity constraints had already started to create restrictions on oil demand growth (Exhibit 2). 1 Commodities in the cross-hairs A commodity shortage lies ahead, Goldman Sachs & Co., August

3 Exhibit 2: Growth in oil demand is being crimped by constraints on supply Source: IEA and GS Global ECS Research. Data as at 31 December A similar story is likely to hold for industrial metals, for which strong emerging market demand growth may quickly absorb excess production capacity. Output of agricultural commodities is also close to 100% due to population growth, declining returns from the so-called green revolution of the 1960s and rising protein consumption among the growing ranks of affluent consumers in the fastest growing emerging economies, such as Brazil, China and India. A better risk-return trade off: The beneficial impact of adding commodities to an investment portfolio As recent stock market turbulence has demonstrated, conventional investment portfolios may carry a higher level of downside risk than many investors realise. 2 Our analysis, using conditional value at risk (CVaR95) suggests that adding commodities to an investment portfolio can help provide some protection from the downside risks associated with severe market events. CVaR95 measures the average real portfolio loss (or gain) relative to the starting portfolio in the worst 5% of market scenarios over a given period, based on 10,000 simulations. This is, simply stated, the average real loss (or gain) that an investor can expect from their portfolio in the worst 500 simulations (5% of 10,000). 2 A full discussion of these higher downside risks is included in Non-normality of market returns: A framework for asset allocation decision making, by Abdullah Z Shiekh and Hongtao Qiao, J.P. Morgan Strategic Investment Advisory Group, May

4 As it only measures downside, CVaR95 captures both the asymmetric risk preferences of investors (the fear of loss being disproportionately greater than the benefits expected from any gain) and the fact that extreme market events often lead to much greater losses than are predicted by traditional risk models. Analysing commodity returns using conditional value at risk In Exhibit 3, column 1 shows a hypothetical core portfolio with USD 1 billion invested in 30% bonds, 55% equity (10% international equity, 40% US large cap equity, and 5% emerging market equity) and 15% alternatives (invested equally in hedge funds, private equity and REITs). The subsequent columns show the impact on a portfolio s risk-return profile of transferring a portion of the alternatives allocation to commodities. Exhibit 3: Commodities may boost return per unit of risk Initial value = USD 1 billion 1: Current Portfolio (%) 2: 5% from Fund of HFs (%) 3: 5% from Private Equity (%) 4: 5% from REITs (%) 5: 12% from Commodities (%) TOTAL BONDS US Aggregate bonds TOTAL EQUITY EAFE US Large Cap Emerging markets equity TOTAL ALTERNATIVES Funds of Hedge Funds Private Equity REITS Commodities Total Expected arithmetic return Expected compound return Volatility Conditional Value at Risk 95 (allowing for non-normality) USD USD USD USD USD Return per unit of CVaR Improvement relative to current portfolio Source: J.P. Morgan Asset Management. 4

5 As we can see, including commodities in a portfolio appears likely to increase the overall return per unit of CVaR95 in all four scenarios illustrated, based on the long-term capital market return assumptions. Of course, more is not necessarily better. An allocation to commodities above 15% - or even above 5% in some cases - may not result in returns significantly better than those highlighted above because of a vastly greater volatility. Rather, the point of this exercise is to demonstrate that commodities deserve due consideration within an investment portfolio s alternatives asset allocation bucket. Downside protection: How commodities offer protection against inflation, deflation and cyclical macroeconomic downturns We have analysed how returns from equities, US Treasuries, investment grade corporate bonds and commodities are affected by changes in inflation, controlling for real GDP growth, the unemployment rate and foreign exchange rates (Exhibit 4). Exhibit 4: Impact of inflation, GDP and unemployment on asset class returns ( ) Asset class Equity Higher inflation Significantly negative Higher real GDP growth Significantly positive Higher unemployment rate Not significant US Treasuries Not significant Negative Significantly positive Investment Grade Corporate Bonds Commodities Not significant Not significant Significantly positive Very significantly positive Source: J.P. Morgan Asset Management. Higher foreign exchange rate Not significant Not significant Not significant Not significant Not significant Not significant Commodities and inflation Our analysis suggests that long positions in commodities are perhaps the closest thing to a pure inflation hedge relative to the other liquid asset classes considered in this analysis. That is because, as our results show, unlike equities or fixed income, commodities exhibit a significant positive return in inflationary environments. In other words, inflation and commodity returns have strong positive correlations. 5

6 It should not be surprising that commodities present a potentially attractive investment opportunity in an inflationary environment as commodity prices typically mirror global pricing trends. As demand for goods and services increases, so does the price of these goods and services, and the price of the commodities which are used to produce those goods and services rises in kind. Commodities and deflation The analysis of the impact of deflation is not as straightforward because history does not provide us with as much prior experience. However, in the absence of an extensive historical track record of deflation, we have used vector autoregressive (VAR) analysis as an insightful alternative. Although conditional on certain assumptions, VAR analysis allows us to measure what the impact of deflation would be on asset classes over both the short and longer term (Exhibit 5). Exhibit 5: Impact of deflation on asset returns Asset class Immediate impact Equity Negative Positive Longer-term impact (3 years) Fixed Income Positive Dissipates Credit Positive Positive Commodities Negative Negative Source: J.P. Morgan Asset Management. Note: Based on VAR analysis; for illustrative purposes only. What we found is that commodities display an unambiguously negative response to deflation. That is not necessarily a disincentive for an investor because that strong correlation may provide lucrative opportunities to take short commodity positions. Indeed, of the four asset classes considered, commodities display the strongest hedging opportunity when shorting against deflation. Once again, it should not be surprising that commodity prices fall in a deflationary environment. As the price of goods and services falls, the price of the commodities which are used in their production also falls. However, as we have seen, this correlation provides excellent opportunities for investors who are able to take short positions in the commodity markets. 6

7 Macroeconomic risks Another obvious question for investors is: how well do major asset classes perform across each of the four stages of an economic cycle? To answer that, we looked at average annualised quarterly returns and volatility (via standard deviation) for four major asset classes during the four stages of a complete cycle (Exhibit 6). Exhibit 6: Average returns for major asset classes during a classic cycle, Asset class Late expansion Early recession Late recession Early expansion Equity 7.84 (5.23) 4.05 (7.21) (4.66) 7.84 (5.30) Government bonds 6.07 (3.07) 9.34 (5.65) (3.18) 4.45 (3.09) Treasury bills 6.55 (0.44) 7.81 (0.47) 5.05 (0.39) 4.45 (0.35) Commodities (4.62) 9.53 (10.59) 5.63 (5.00) 8.48 (6.05) Source: GS Commodity research. Note: Each entry in the table represents the annualised quarterly return between 1970 and 2006, followed by the quarterly standard deviation around the average return. From this simple analysis, we can see that commodities tend to perform better than the other three asset classes when the economy is in a late expansionary phase and as the economy enters recession. In the latter part of a recession, equities and bonds seem to outperform, while in an early expansion, commodities regain the upper hand. In this respect, historically speaking, an opportunistic allocation to commodities would seem to have been most logical just as an economic recovery got underway. Our analysis suggests that commodities behave very differently from other asset classes across the economic cycle. Investors should recognise that commodities are likely to suffer periods of underperformance compared to other asset classes during certain economic conditions and that they can be negatively impacted by geopolitical uncertainty. However, commodities offer the potential for lowly correlated macroeconomic diversification within a long-term strategic portfolio. 7

8 Active commodities management: Exploiting indexbased market inefficiencies Many investors choose to allocate to commodities via a passive strategy that aims to replicate a major commodities index. However, these index strategies give investors no influence on their allocation to various individual commodities or commodity-linked sectors. In contrast, investing in commodities via actively managed vehicles such as long-only funds and hedge funds can provide opportunities to exploit market inefficiencies and boost long-term returns. Markets in individual commodities often move independently of each other, determined by their own unique supply and demand dynamics. Indeed, our research shows that correlations among commodities tend to be low due to highly specific supply-side factors and demand elasticity. It is because of these low correlations that active rotation among commodity sectors may allow for more consistent returns than are possible by simply investing in a broad basket of commodities through an index. Investing in commodities via a passive index only enables an investor to access commodity futures that are traded on regulated exchanges. Since not all commodities are available on exchanges, passive indices are limited in terms of the commodity markets they can reach. In contrast, active management enables an investor to access a wider variety of commodities, including those traded on equity markets and other exchanges. Exhibit 7 shows some of the chief commodity exposures offered by active and passive strategies respectively. Exhibit 7: Types of commodities exposure - how active and passive strategies compare Active Energies Agriculture & Softs Metals Passive Energies Agriculture & Softs Metals Water Power Electricity Paper & forestry Shipping/ transport Chemicals & building materials Peripheral base metals Coal & other alternative energy Emissions Source: Cole Partners. 8

9 Relationships between commodities can help predict price movements To illustrate the potential for active management in commodity investments, we developed a case study showing how the causal links between different individual metal prices can be exploited by active managers. We looked at the relationship of different metals to a broader metals index using Grainger Causality a statistical analysis that reveals potential causal relationships between variables. We found that there are many relationships between different metals that can cause prices to lead or lag one another. For example, we found that historical prices of nickel could help inform an investor about the likely price of aluminium. It is conceivable that this apparent close relationship stems from the fact that nickel, which has corrosion resistant properties, is commonly used in aluminium-based and other alloys. 3 Our analysis does appear to suggest that there is ample opportunity for an active portfolio manager to identify and potentially exploit linkages between and among individual commodities, thereby gaining higher returns than would otherwise be possible by investing in a passive index. Long and short exposures can exploit inefficient markets Active commodity management is also not constrained to long-only strategies. Active managers can draw on a number of different strategies in an attempt to generate return over and above the benchmark index, such as using seasonal factors in agricultural and energy commodity markets to dictate whether long or short positions in a particular commodity should be implemented. In sum, the question of whether to invest in commodities via a passive index or through active management amounts to whether investors want access to the additional markets and strategies which are the preserve of active management. Investing passively enables investors to access the beta returns of the commodities market, taking advantage of supply and demand imbalances and market shocks. Investing actively, on the other hand, enables investors to exploit volatility and inefficiencies through taking positions, both and long and short, in a wide variety of commodity markets. The wider range of strategies and opportunities offered by active management can lead to potentially higher returns. However, correlations between active and passive strategies tend to be very low. So some investors may find it beneficial to invest partly in a passive index and partly in an actively managed strategy, thereby profiting from diversification within a commodities allocation. 3 A much more detailed analysis of this case study is included in the longer version of this paper A global cornucopia Accessing commodities in a long-term portfolio, published by the J.P. Morgan Strategic Investment Advisory Group in October

10 Strategic Investment Advisory Group The J.P. Morgan Asset Management Strategic Investment Advisory Group (SIAG) is one of J.P. Morgan s primary providers of thought leadership and advisory services for institutional clients in the areas of asset allocation, pension finance and risk management. This investment insight is an abridged version of a much longer SIAG paper called A global cornucopia Accessing commodities in a long-term portfolio. Please contact your usual J.P. Morgan Asset Management contact if you would like a copy. Conclusion Commodities do involve higher risk profiles and may be best utilised to complement larger allocations to other asset classes. However, our research suggests that adding commodities to a balanced portfolio may help diversify and potentially bolster long-term investment performance. Commodity prices are currently supported by ongoing strong demand from China and other emerging markets. Current supply constraints mean demand is likely to continue to outstrip availability of many commodities for many years to come. An investment in commodities can potentially boost risk-adjusted returns, offer protection against inflation and provide diversifi-cation benefits across the business cycle. Even in a deflationary environment, investors can benefit from taking short positions in the commodities market. Active management provides greater opportunities to boost returns, taking advantage of market inefficiencies and causal relationships between commodities through both long and short exposures. Amid persistent uncertainty in the global marketplace, we therefore believe that an allocation to commodities may help better protect investors portfolios from a wide spectrum of macroeconomic risks. FOR PROFESSIONAL INVESTORS ONLY. NOT FOR PUBLIC DISTRIBUTION. Any forecasts, figures, opinions or investment techniques and strategies set out, unless otherwise stated, are J.P. Morgan Asset Management s own at March They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. They may be subject to change without reference or notification to you. The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance. Changes in exchange rate may have an adverse effect on the value price or income of the product. Investments in smaller companies may involve a higher degree of risk as they are usually more sensitive to market movements. Investments in emerging markets may be more volatile and therefore the risk to your capital could be greater. Further, the economic and political situations in emerging markets may be more volatile than in established economies and these may adversely influence the value of investments made. You should also note that if you contact J.P. Morgan Asset Management by telephone those lines could be recorded and may be monitored for security and training purposes. J.P. Morgan Asset Management is the brand name for the asset management business of JPMorgan Chase & Co and its affiliates worldwide. Issued by JPMorgan Asset Management (Europe) Société à responsabilité limitée, European Bank & Business Centre, 6 route de Trèves, L-2633 Senningerberg, Grand Duchy of Luxembourg, R.C.S.Luxembourg B27900, corporate capital EUR Material issued in the United Kingdom are approved for use by JPMorgan Asset Management (UK) Limited, 125 London Wall, London EC2Y 5AJ, England. JPMorgan Asset Management (UK) Limited is authorised and regulated by the Financial Services Authority. Registered in England No Registered address: 125 London Wall, London EC2Y 5AJ. 10